Investment Dictionary

Risk-Free Interest Rate

A risk-free interest rate is rate of interests that would be paid by fixed income securities that contains no risk at all.

For a very long time short-term US Treasury securities was used to determine risk free interest rate. However, in current economical and fiscal situation would be hard to be convinced that US securities are risk free (at least the nominal ones). The closest benchmark to risk free rate now could be bonds issued by the German government, but they are not pure risk-free either. Everything in our world contains some portion of risk.

The importance of risk free rate is very high in theory of investment valuation. The principle is that every investment return is compared to risk free return according to the additional risk. Basically risk free rate is a part of cost of debt and cost of equity. It can be harder to determine the risk free rate in other currencies than the benchmark currency.

Those yields represent risk free rate, if we believe that US and German government bonds are totally riskless, if we would not believe then some adjustments should be made. But most of times you won’t be needed for adjustments if investment (under valuation) is in the same country because it will be dependable on country risk too. But if the investments are different country and you need to find a pure risk free rate it may get more difficult.

Remember, that during determination of the right risk free interest rate you have to choose the yield of the bond that has maturity similar to your investment’s horizon.

The currencies also have to be identical. If you can’t find a risk free benchmark for some specific currency, you may use real risk free interest rate and then add to it inflation of that currency and a country risk.

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